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The hidden upswing in corporate earnings

Some economists have downgraded growth forecasts, but this is misleading.

Summary: The Reserve Bank of Australia and a number of economists have downgraded their growth forecasts for Australia in the last month, pointing to weakening terms of trade and an earnings season where cost-cutting was a central theme. This is misleading, as earnings and sales growth remains solid when excluding the resources sector.

Key take-out:The best way to look at company earnings and the outlook for earnings growth isn’t through the prism of declining terms of trade and weakening economic growth, but rather through sales growth and volumes – which are strong in many sectors.

Key beneficiaries: General investors. Category: Shares.

Australia is undergoing a downgrade period at the moment. The Reserve Bank of Australia downgraded its growth forecasts about a month or so ago, and recently a number of economists have followed suit.

That the Aussie share market has rallied hard in that environment has, in part, underpinned calls that our market is expensive. I appreciate that, but I’m not going to go into the concept of value again. Suffice to say that investors need to be very careful about using past notions of value in this current market – in this new, money printing, ultra-low rate world.

In any case, I think all of the recent growth downgrades and talk of a disappointing earnings season are a bit misleading. It is a popular view, however – the consensus view for certain – and one underpinned by the chart below.

Chart 1: Australia’s tanking terms of trade

According to this view, the slump in the terms of trade is smashing national income. We are poorer and that affects the budget, jobs, consumer spending, investment, company earnings and national economic prosperity more generally. It is this chart which underpins repeated calls for a downturn.

It’s true to say that the slump in the terms of trade is having an effect on the equity market and chart 2 below shows that corporate earnings are being smashed. So far, everything would appear to support the consensus view that the economy is in trouble.

Chart 2: Corporate profits are weakening

As the chart shows, profits have fallen dramatically. In level terms, we are back to where we were a year ago. In terms of growth, total company earnings are down some 17 per cent over the year to the December quarter, which also just happens to be the weakest December outcome since the GFC.

But that chart doesn’t actually capture what’s going on. It’s much more complicated than what a casual glance at such aggregate numbers show. More complicated, but nowhere near as scary.

Take our miners and resource companies, which have obviously had a hard time given commodity price declines. While it’s fair to say BHP didn’t report such a strong result (with a 47 per cent slump in net profit with revenues down about 7 per cent), Rio still managed to post a 78 per cent lift in net profit.

Outside of the resource sector though, things don’t look so bad – and this is a point often overlooked by the broader market. Take a look at Chart 3 below.

Chart 3: Non-mining profits are solid

Chart 3 shows that from a low in mid-late 2011, non-mining profits have shot up by about 27 per cent or about 8-9 per cent each year. That’s pretty solid growth. Note the trajectory – profit growth is on a clear uptrend.

It’s a chart that dispels the myth that the slump in the terms of trade is delivering a broad-based shock to the economy. It also helps to explain why the nation is seeing the strong jobs growth it is seeing with more than 280,000 jobs created over the last year. Companies are making money.

One of the critiques of the earnings season, however, is that much of those better-than-expected results came from cost-cutting. For many analysts, it was a key theme of the earnings season. In some cases, such as Rio, this is certainly true and costs to income ratios have declined in the banking sector as well. Yet it isn’t true to make this claim as a broad-based observation.

For a start, while the sales and revenues of our large resource stocks aren’t flash in nominal terms, volumes growth is extraordinary. This is important, because it tells you that the key driver of lacklustre revenue isn’t demand – this is not a demand driven slump in revenue. It’s a merely a price issue.

At some point, prices will stabilise and then we shall see revenue growth that is more reflective of this spectacular production growth.

Also take a look at chart 4 below. It shows that outside of the resource sector, some sectors are reporting strong sales growth. People are spending money – companies are making good profits. It’s just that in some cases, these profits are being distorted temporarily by price falls.

Chart 4: Sales and revenue growth in many sectors is strong

With that in mind, the best way to look at company earnings and the outlook for earnings growth isn’t through the prism of declining terms of trade and weakening economic growth. The more accurate observation is that money is still being made and the trajectory is up. The broader trend is that profits are not being driven solely by cost-cutting (which has the implication that there are limits to cost-cutting – and thus profit growth).

Instead, jobs growth is strong, credit growth is rebounding, sales of SUVs are at a record and the country is enjoying a surge on construction – all at the same time that input costs are falling. That’s not a bad environment for earnings at all.

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